Today’s Q&A came from a recent service academy graduate. I originally intended to answer this just as a normal Q&A, but it’s also a good lead in to a lesson on investing.
I’m thinking of taking out a USAA Lieutenant Loan and using it to invest. Do you think this is a good idea?”
Note for my civilian readers: the “Lieutenant Loan” is the colloquial term for the USAA Career Starter Loan. It’s a loan of up to $25,000 at a 2.99% APR. Payments start 6 months after commissioning into the service if taken out before commissioning. If the member has already commissioned, the payments start after 45 days. The member has 5 years to pay back the loan. The loan is also known as a Cadet Loan or Commissioning Loan.
Investing On Leverage
This process of taking out a loan in order to invest the money is known as “investing on leverage.” Taking out a loan to invest in the stock market doesn’t seem to be too terribly common, although as you’ll see later there is a common way that many people use leverage to invest their money.
Benefits of Investing on Leverage
Fans of investing on leverage will tell you that you can increase your potential return. This is because you have more money in the game. The percentage of the return won’t change – you can’t control that – but the dollar amount will be higher.
For instance, let’s say you have $1,000 to invest. If you put that $1,000 into an investment and it earned 8%, at the end of the year you would have $1,080, right? Because $1,000 times 1.08% equals $1,080.
(Yeah, okay, it would be slightly more because it would actually earn money daily or monthly and then that money would earn interest too. I’m using a simple example here)
Okay, let’s say instead that you took out a loan to invest on leverage. For instance, the Career Starter Loan. Now you have $26,000 to invest ($25,000 from the loan and your original $1,000). If that $26,000 earned the same 8%, at the end of the year you would have $28,080. You would have earned $2,080 instead of just $80.
Here’s where the “increase your potential return” part comes in. Proponents of investing on leverage will say you earned a 208% return on your $1,000, instead of 8%. This is because you only used $1,000 of your own money. That is one way of looking at it, I guess. But…
Risks of Investing on Leverage
When you invest on leverage, you are taking on debt to get temporary control of that money. In my mind, you are still earning 8%, because that money has temporarily becomes yours. But it comes at a price.
Investing on leverage exposes you to a higher than normal level of risk. Not only are you accepting the risk of the investment, you are also accepting the risk of not being able to pay off the debt on time.
You see, normally you would be investing with money you already have. It might be very, very painful if you were to lose it all, but since the money already belonged to you the lowest position you could be in is to have zero dollars.
But if you invest on leverage, you are investing with money that doesn’t permanently belong to you. And if you lose it all, you still have to pay it back. So now not only have you lost your investment money, you also have a debt to pay off.
Let’s say our example from above lost 3% instead of gaining 8% that year. With the $1,000 investment, you’d be down $30. With the $26,000, your year-end total would be $25,220. You’d be down $780 instead of $30. Plus, you still owe interest on that $25,000, so you are actually down even more.
In this case, investing on leverage doesn’t seem like a very smart idea to me.
Follow-Up Question
But then the cadet asked a follow-up question. She said she was pretty risk adverse, so she wanted to put the money into an investment with a guaranteed rate of return.
I know what you are thinking. Well, I hope I know what you are thinking. “There are no guaranteed returns on investments.” If you are investing in the stock market that’s true and I don’t dispute it. But what if you are putting the money somewhere else? Something less like investing and more like saving?
If she were to take out the loan at 2.99% interest and then stick it into a CD earning 5% (those used to exist and hopefully will again!) she could have earned some money with essentially no risk.
Alternatively, we are talking about a military member here, right? If a new accession into the military finds out they are deploying in the first year of their career, they could always take out the Career Starter Loan to fund their Savings Deposit Program. You don’t have to take out the full $25,000, so in this case I’d recommend taking out the SDP max of $10,000. At the end of the deployment, the loan could then be paid back in full and the difference pocketed. That’s an incredibly low risk way to use the Career Starter Loan to make some money!
When Is Investing On Leverage A Good Idea?
Personally, I think investing on leverage is too risky for the average investor. Especially one who says they are risk adverse! But there are some people who can probably stomach the risk.
If you have a very high risk tolerance and enough income to cover the loan if you lost a significant amount of money, investing on leverage may be okay for you. For instance, I currently invest $525/month outside of my retirement accounts. That would more than cover the monthly cost of repaying a $25,000 loan at 2.99% interest. So if I were to come across an investment opportunity where I needed the money now instead of putting in the $525 monthly, investing on leverage could work for me.
When you think about it, that’s exactly what you are doing when you take out a mortgage on a rental property. You are taking out a loan with the expectation that your investment will return more than the cost of the loan. But of course, the mortgage company will (now, post-Great Recession) do their homework to make sure you have enough money to cover the loan if the investment falls through.
And if you have an investment opportunity with a very low risk and a higher return than your interest rate on the loan, it may also make sense to invest on leverage.
But if you are a risk adverse investor, I wouldn’t recommend taking out a $25,000 and putting it into the stock market. The payback period on the Career Starter Loan (5.5 years total including the deferment period) is too short for a risk adverse person. During a 5.5 year period, you may not earn enough money to make the investment worthwhile.
More Reading
I’m certainly not the only person who has written on this topic, so if you’d like some different perspectives here are some articles I recommend.
Gentle reminder: I am not a personal finance professional. You should always do your own research before making changes to your finances and talk to a professional if you need additional help. Please read my full disclaimer here.
Do you think investing on leverage is a good idea? Why or why not?
Using a low-interest loan to put the maximum allowable amount into the Savings Deposit Program is a great idea! It’s as close to a guarantee as you can get.
When the economy goes south, let’s revisit this. I’ll bet many of us will at least entertain the thought of taking out a low-interest loan to invest more into the market.
Interesting. I would have thought people would be too scared at that point, haha! But maybe you mean the money smart people? 😉
I’m pretty conservative when it comes to our personal finances; so I can’t think of too many situations where I would invest using leverage. The CD scenario that you point out is one thing I would consider, but I would imagine it’s unlikely to get a loan rate lower than the CD rate. For the Career Starter Loan, does the borrower need to show that the funds are going towards education?
On the real estate investing front (which is years away for us if we end up going that route), I’m torn on taking out loans. I can see the benefits, but I still don’t like debt.
No, the Career Starter Loan is specifically intended for post-education expenses. You actually can’t apply until you are approaching graduation. The suggested uses are buying a reliable, economical car (they actually say that! 😎), consolidating credit card debt, using it for an emergency fund (😕), or paying for transition expenses like buying furniture.
I don’t have a problem taking out a loan on a property, even though I’m anti-debt. But I am torn on whether to pay it off early. I know the math often says to invest instead, but being debt free is soooo nice!